The spreads between the prices of different grades of crude oil have compressed sharply in the past few months. The West Texas Intermediate (WTI)-Brent differential has narrowed from approximately $20 per barrel (bbl.) in the beginning of the year to $1 bbl. at the first of August.

Toward the end of that time period, WTI even hit a brief premium to Brent, a phenomenon not witnessed in nearly three years—and the implications of which could be major.

The huge upward swing in WTI relative to Brent has been attributed to a number of factors, some of which are temporary, such as reduced availability of Canadian syncrude due to flooding, and some of which reflect longer-term structural changes, such as better infrastructure, reduced Gulf Coast imports and the restart of BP’s Whiting, Indiana, refinery.

This rapid and greater-than-expected contraction has led to a flurry of questions from investors about the outlook for spreads going forward and the impact on oil refiners and transporters.

A consistent theme on the second-quarter earnings conference calls was how the tightening crude differentials pressured downstream profitability for the integrated majors and the independent refiners alike. For example, ExxonMobil’s downstream earnings were down to approximately $400 million compared to more than $6.6 billion in the prior-year period.

On those earnings calls, corporate management teams said that they expected oil spreads to widen again later this year, but they also indicated they were not anticipating a return to more profitable, double-digit differentials in the near-term. Valero mentioned specifically that they forecasted WTI to expand to a $7 per bbl. discount relative to Louisiana Light Sweet (LLS) prices on the Gulf Coast.

It’s been troubling for investors that there has been no consensus on spreads from the analyst community, with estimates showing very wide ranges. While broadly it is thought that differentials should expand by at least enough to accommodate the transportation costs to move barrels to market, some analysts are even more bullish regarding the outlook for wider spreads in 2014.

Crude by rail

The volatility in oil spreads not only wreaked much havoc on shares of refiners, but it also raised some questions from the investment community about the economics of the crude-byrail (CBR) growth story. Several large refiners, such as Phillips 66 and Valero, indicated that they have already reduced their rail shipments of Bakken crude and instead are increasing their use of imported international crudes.

According to JPMorgan, the impact of this is showing up in rail volumes as average weekly petroleum products volumes from the railroad industry fell from 20,600 carloads in May to 19,000 carloads in July, a 7% decline. Morgan Stanley estimates that rail movement slowed from 65% of total Bakken production to 35% over the quarter.

Several midstream companies also indicated on their earnings calls that tighter oil spreads adversely impacted their CBR activity. For example, Plains All American mentioned a reduction in crude oil volumes into its rail-receiving facilities.

The rail market at greatest risk for downsizing is the market for sending Bakken crude to refineries on the East Coast where Bakken crude has been used as an alternative for Brent. By contrast, rail volumes to St. James , Louisiana, have remained strong, reflecting the fact that the spread between Clearbrook, Minnesota, a key Bakken hub, and LLS on the Gulf Coast, sits above $11 per bbl., which is close to the marginal cost of transportation.

Relative to last quarter, Gulf Coast crude differentials actually improved slightly while inland crudes continued to get more expensive. However, infrastructure expansion is ultimately expected to alleviate supply tightness in the Gulf market and soften the LLS premium, which could cause eventual pressure on CBR into this market as well.

While the sharp compression in oil-price spreads does affect the economic attractiveness of shipping crude oil via rail, the recent earnings calls of most refiners, midstream operators and producers alike suggested that in the medium to longer term, transporting oil by rail will not only remain a viable strategy but a key component of the North American crude oil-transportation network.

Companies across all areas of the energy value chain indicated that they are continuing to move forward with their investments in new rail-terminal infrastructure to handle additional volumes. But, while inland crude oils will not sustain pricing supremacy over (or parity with) seaborne grades over the long haul, near- and medium-term spreads will continue to experience volatility as various pipelines come online.

Investors must therefore understand the dynamics of rail costs in order to determine how to weather the gyrations in the margins for Midcontinent and Gulf Coast refiners and the impacts on the midstream operators in these markets.

Looking ahead, however, the structural problem for U.S. oil prices—why they have traded at a discount to international grades—will not be addressed by enhanced domestic-transportation infrastructure. Ultimately, U.S. crudes will remain cheaper than global benchmarks due to the inability of American refiners to efficiently process the surging supplies of light, sweet oil.

As such, unless the U.S. lifts the ban on exporting crude oil, the U.S. oil price discount will re-emerge and will potentially expand to other regional grades.

Comments